Section 1 - Covered Call Writing: Basic Terms and Definitions

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1 Section 1 - Covered Call Writing: Basic Terms and Definitions Covered call writing is one of the most often-used option strategies, both at the institutional and individual level. Before discussing the mechanics and applications of this strategy, a quick review of basic terms and definitions that relate to call options is in order. Download this in PDF format. Options are contracts between two parties: the buyer of the option, and the seller of the option (also referred to as the writer or the grantor). An equity call option gives its buyer the right, but not the obligation, to purchase 100 shares of the underlying stock at a specific price (the option s strike price, also known as its exercise price) at any time until a fixed date in the future (the option s expiration date). The writer of an equity call option assumes an obligation to sell 100 shares of the underlying stock at the option s exercise price if assigned at any time before the option s expiration. The standard shorthand form for describing an option contract is as follows: XYZ September 25 Call XYZ : This is the ticker symbol of the underlying stock. Each option contract covers (gives its buyer the right to purchase) 100 shares of the underlying stock. September : The option s expiration month. Although technically options expire on the Saturday immediately following the third Friday of the expiration month, the date that is of particular importance is the third Friday. This is the option s last trading day, and the last day on which the buyer of the option may exercise it (see below). In our example, this call option would trade until the close of business on the third Friday in September (Sep). 25 : The option s strike price. The buyer of this option obtains the right to purchase 100 shares of the underlying stock at $25. The writer has assumed the obligation to sell these shares at $25 if assigned. Call : There are two types of options, calls and puts. Puts give their buyer the right to sell the underlying stock, but we need not be concerned with these as the subject of this course is limited to writing equity calls options. In addition to understanding the standard option shorthand, knowing the meaning of the following terms will help you in this module: Premium : The price at which an option trades - paid by the buyer of the option and received by the seller of the option. Option premiums are quoted on a per share basis. For example if the XYZ Sept. 25 calls are trading at $2, this means $2 per underlying share. Since there are 100 shares underlying each option contract, buying one of these calls would cost $200, and the writer of one of these calls would receive $200. To exercise : The buyer of any equity option who holds that contract in a brokerage account has the right to exercise it at any time before it expires. For example, if the holder of an XYZ Sep 25 call exercises this contract he would receive 100 shares of XYZ, and in return must make an aggregate payment of $2500 ($25 per share times 100 shares) for the stock. The holder of any equity option contract exercises it by instructing his brokerage firm to do so. To be assigned : Whenever the buyer of an option exercises it, someone else is assigned. For example, if an investor sold a XYZ Sept. 25 call she may be assigned on this short contract. That is, she may be called upon to fulfill the obligation she assumed when writing the contract. If assigned on an XYZ Sept. 25 call, the investor would have to deliver (sell) 100 shares of XYZ stock against which delivery she would receive $2500 ($25 per share times 100 shares).

2 Contingent obligation : The writer if any option contract is said to assume a contingent obligation, meaning that he may or may not be asked to fulfill this obligation. This means that for the writer of an equity call option there is a certain amount of uncertainty as to whether or not the obligation will have to be met. There are, however, instances when an investor can determine that an assignment is very likely or very unlikely. Covered call : The writer of an equity call option assumes the obligation to sell 100 shares of the underlying stock at a given price. If the writer of this option owns 100 shares of stock she is said to be covered, as she can fully meet her obligation with the shares already owned. There is no margin required when selling covered calls, i.e., the investor does not have to post any additional cash or securities other than the stock underlying the short call options. A call writer who has written calls is said to have a short position in these options. A call writer who does not own the underlying stock is said to be writing uncovered (or naked) calls; this course does not cover uncovered call strategies. Because all options have a finite life (i.e., their expiration dates are known), writers of covered calls will either have to do something with their position before option expiration, or do nothing and live with the consequences. If an investor has written calls and decides to do nothing, that is she will maintain the short option position until expiration, she will either see the options expire worthless (when they are out-of-the-money at expiration), in which case her potential obligation to to sell her shares will be terminated, or, she will be assigned (if the options are in-the-money at expiration) and forced to sell shares of the underlying stock. If the investor decides to do something, before expiration she could buy back the calls she had previously sold and by doing so terminate her potential obligation. If an investor buys back (or covers ) options previously written, she may be doing so at a profit or at a loss. For example, if an investor sold some March 55 calls at $2.50 and repurchases them at $4.00, she would have a $1.50 loss per share, or $150 per option contract. The price of the calls on the date they are repurchased will be a function of the stock s price, the time left until expiration and other pricing variables. Roll your mouse over here to view additional information on fees that may impact profitability that are not included in this example. Section 2 - Writing Covered Calls Writing Covered Calls against a Long Stock Position Assume an investor currently holds 600 shares of XYZ, trading at $28. He purchased these shares at a lower price and has determined that $30 represents a fair target price at which he would be more than willing to sell his shares. One alternative is for him to simply wait until XYZ reaches $30 and then sell the stock in the marketplace; a second alternative is to write covered calls. The XYZ February 30 calls (with 55 days until expiration) are trading at $1.20. The investor decides to write 6 of these calls, thereby obligating himself to sell his 600-share position at $30 if assigned. In other words this investor is writing calls to pre-sell shares he owns at his target price. What are the possible outcomes, the advantages and disadvantages of entering into such a strategy? First, let s review the possible outcomes: If XYZ rallies and is above $30 at option expiration in 55 days, then in all likelihood the investor would be assigned in the in-the-money written calls and be obligated to sell is 600 shares at $30 per share. Note that the stock could be trading a a price substantially higher and by being forced to sell at $30, this investor would suffer an opportunity loss. But if his goal was to sell the shares at $30, then his goal was met. Second, XYZ could be unchanged (or increase slightly) and close below the $30 strike at expiration, with the written calls expiring out-of-the-money and worthless. At this point the investor will still own his XYZ shares, his obligation to sell these will be terminated, he will have realized a $1.20 profit on the

3 calls initial sale. He would then be in a position to sell another series of call options (for example the April 30 calls) if he is still willing to sell his XYZ shares. Finally, XYZ could fall in price below $28 over the coming two months. In this case the investor s accrued but unrealized profit on his XYZ would be reduced by the amount of the stock s decline. This loss, however, would be partially offset by the $1.20 gain the investor realizes on the expiring out-ofthe-money call options. Advantages of writing the XYZ February 30 calls at $1.20: $1.20 per share profit will be realized if XYZ is unchanged over the next 55 days If XYZ retreats, the calls offer partial downside protection, reducing the losses on the stock by $1.20 This strategy helps an investor stick with a set target price for selling the underlying shares. Some investors may find that writing covered calls on stocks they own helps them with trading discipline and forces them not to constantly change their target prices. Disadvantages of writing the XYZ February 30 calls at $1.20: Downside protection is limited to $1.20: Investor may suffer an opportunity loss if XYZ rallies substantially above $30. If the investor s opinion on the underlying stock changes, exiting the covered write prior to expiration is more complex than simply selling the shares, as the written options must also be repurchased (covered). Section 2 - Writing Covered Calls Writing Covered Calls as an Alternative to Open Orders Some investors view writing covered calls as an alternative to entering an open sell order. Someone who enters an open sell order for a stock that they own is saying: "If these shares go up to $45, I will sell them". Someone who writes the 45 calls on these same shares is saying: "If these shares go up to $45, I will sell them". But there are subtle differences, as well as many similarities, between these two strategies. Let s look at them in more detail. Cash flow : There are no costs in entering an open order but neither are there any tangible benefits. By writing covered calls an investor will pocket the options premium as positive cash flow is generated. Result if stock unchanged : If the stock is unchanged by the options expiration date, the call writer will have a profit equal to the options premium and will still hold her shares. The investor who placed an open order will still have a long stock position, but neither profit nor gain. Result if stock down : If the price of the underlying falls, the investor who placed an open order will be accruing unrealized losses (or seeing her accrued gains diminish); the same situation will exist for the covered writer, except that he will keep the option premium which will fully or partially offset the losses (or reduced profits) on the stock. Stock briefly hits target price : Assume an open sell order was placed at $45 by one investor, and the 45 calls written by another. If the stock rallies briefly above $45 the investor who placed the open order will sell his shares (assuming the stock rises to any price above $45). The covered writer may not be assigned on her short calls if the stock rises briefly above $45 and then retreats to a lower level. The odds of selling shares at $45 are therefore better for the investor who places the open order (stock only needs to trade above $45 once) than for the covered writer (stock needs to be above $45 at option expiration). Cost of changing one s mind : The investor who places an open order can cancel this order or change the target price at any point in time, at no cost, so long as she does so before her shares have been sold. The covered writer who decides to change his mind, either canceling his obligation to sell outright, or moving his target selling price higher, will have to re-purchase the calls sold and may be

4 doing so at a profit or at a loss. For the covered writer, it is impossible to tell if there will be a cost associated with changing his mind. So an investor who is considering writing covered calls as an alternative to placing an open sell order for a stock held must weigh the following: receiving the options premium which will lead to out-performance if the stock does not rise to the target price versus the higher probability of selling the stock through an open order and the unknown cost of changing one s mind sometime in the future. Section 2 - Writing Covered Calls Will My Short Calls Be Assigned? There may be situations when the covered call writer may not be able to reliable predict whether he is going to be assigned or not at expiration. We will try to clarify a few of those here. First, let s look at what can be termed as certain. If on expiration Friday the stock underlying the short calls closes $0.25 or more above the options strike price (i.e., $0.25 or more in-the-money), The Options Clearing Corp. (OCC) will automatically exercise the calls so investors who have written such calls can be reasonably sure that they will be assigned. An exception to this rule is when the OCC receives instructions from a client instructing it not to exercise calls in-the-money by less than this $0.25 threshold, a very rare occurrence indeed. Second, there is a zone of uncertainty. If on expiration Friday the stock closes in-the-money but by less than $0.25 it is up to the individual option holders to decide whether or not to exercise their calls. Remember that some of these holders may be professional option traders who will exercise for a penny or two, as they are reluctant to leave any money on the table. Therefore, the more the calls are in-the-money the higher the probability of being assigned. On relatively rare occasions, calls expire in-the-money by 10 or 20 cents and are not exercised, and therefore not assigned, but these are truly few. Third, what if the stock closes at exactly the options strike price at expiration. It would appear that there is no gain to be had by exercising such an at-the-money option, but it happens occasionally. Why? It can be difficult to tell. Maybe a professional trader is unwinding a spread and this is the easiest way to do so. Or perhaps someone makes a mistake (always possible) or gives unclear instructions to his brokerage firm. Remember that the decision whether to exercise or not is in the hands of the option buyer and what may appear to us as "irrational behavior" may make sense to some in certain circumstances. Fourth, what about early assignment? Equity options are American style, which means that their holders have the right to exercise them on any business day up to and including the third Friday of the expiration month. This means that theoretically, a short call option could be assigned early, especially if it s in-the-money by a significant amount. So yes, there is a risk of being assigned early. Early Assignment All equity options are American-style options, which means that their holders (buyers) have the right to exercise them on any business day, up to and including expiration Friday. The flip side of this, is that the writer of an equity option is at risk of being assigned early. Two questions need to be answered: can the risks of early assignment be quantified, and is early assignment a negative or a positive? To quantify the risk of being assigned early on written calls, it is best to view this question from the perspective of the option holder, the investor who purchased call options. Assume an investor purchased some September 50 call options. The underlying stock is now trading in the $54-$55 range. Should this investor exercise his options early? The 50 calls give this investor the right to purchase shares at $50. He could do so today, but he could also do so tomorrow. Is there any advantage in exercising this right today? Not really. Is there any point in waiting until tomorrow?

5 Yes. Assuming that this investor has the cash necessary to purchase the underlying shares, waiting until tomorrow to exercise means postponing the purchase by one day. This means that the cash can be retained and earn interest for an additional day. Of course, tomorrow the same analysis can be made again and the purchase deferred another day to earn another day s worth of interest. The option holder has one very good reason to postpone exercising his calls: the longer he waits, the longer his cash earns interest. Therefore, early exercise/assignment of calls is relatively rare as there is no economic justification in spending money today when it can be spent later. There is, however, one exception to this, and that is when the underlying stock is about to go ex-dividend. The question facing the call holder is: do I wait until immediately prior to expiration and keep earning interest on my cash, or do I exercise on the day before the stock goes ex-dividend, spend the cash early but collect the dividend? When equity calls are exercised early it is in most instances for a dividend. Call writers should therefore be aware that the risk of early assignment is at its highest immediately prior to the underlying stocks s ex-dividend date. But is being assigned early a negative event? The writer of a covered call knows that at best she will sell her stock for the options exercise price. Being assigned early simply means selling the underlying stock earlier rather than later, and at the same price. Most investors would prefer to get paid today rather than tomorrow, and early assignment may be viewed as a positive. Holders vs Stockholders Rights Why Exercise a Call for a Dividend? Qualified Covered Calls Investors should be aware that writing in-the-money covered calls may have an effect on the holding period of the underlying stock. If in-the-money calls are written and these are classified as qualified covered calls, then the holding period of the underlying stock is suspended (the time meter is turned off, but not reset to zero); if the in-the-money calls are not classified as qualified covered calls (i.e., they are deemed to be too far in-the-money), then the holding period for the underlying stock is terminated (the time meter is reset at zero). For more information on what constitutes a qualified covered call please refer to the Taxes and Investing brochure prepared by Ernst & Young LLP. Click here to access an on-line version of this brochure. Section 3 - The Buy/Write If the starting point of the covered call discussion in the previous section was an investor with an existing long stock position looking to cash-out by selling it at a target price, the starting point of this buy/write discussion is an investor looking to invest cash instead. Here is what we mean: the buy/write is the new purchase of underlying shares, and the simultaneous writing of covered call options. For example, an investor could purchase 300 shares of XYZ at $62 and simultaneously write 3 of the June 65 calls at $2.30 per contract. At most brokerage firms, both the purchase of the stock and the sale of the calls can be entered as one order. Roll your mouse over here for more information on entering buy/write orders. Net Debits/Credits A Return Based Strategy The buy/write is primarily a return based strategy; that is to say investors enter into it looking to earn a specific rate of return. Most investors who establish a buy/write calculate two rates of returns before entering into the strategy: the static and the if-called return. Calculating the initial investment : The premium received when call options are written can be used to partially pay for the purchase of the underlying shares. For example, an investor who purchases shares of

6 XYZ at $28 and simultaneously writes the December 30 calls at $1.10 can use this $1.10 to partially pay for his shares. His initial investment is therefore only $26.90 (i.e., $28 less $1.10) per XYZ share. This is the cash that would be necessary to initiate the buy/write and represents the investor s initial investment. This also represents the downside break-even on the overall strategy, i.e., the buy/write will show a loss at option expiration if XYZ falls below $ Calculating the static return : The static return answers the question: What will the strategy s return be if the price of the underlying stock remains unchanged? For example, an investor purchases XYZ at $57 and writes the August 60 calls at $1.70. August options have 70 days until they expire. What will be this investor s static return? The profit on the strategy, assuming an unchanged stock price, will be $1.70, the option s premium. Remember that if the price of the stock remains unchanged the calls will expire worthless as they will be out-of-the-money. The investor will still hold the shares of XYZ (still worth $57) and will have a gain of $1.70 on the expiring options. The static return will therefore be: $1.70 profit / ($57 - $1.70) cost of shares = 3.07% It is customary to annualize returns calculated for buy/writes. This is done by dividing the actual return by the number of days until expiration and multiplying by 365: (3.07% X 365) / 70 = 16.0% annualized If the stock pays a dividend and if the investor is entitled to receive one or more dividends over the term of the strategy, then the dividends received should be added to the strategy s profit. Roll your mouse over here for clarification. Section 3 - The Buy/Write Calculating the if-called return : The if-called return answers the question: What will the strategy s return be if the underlying stock rises above the options exercise price, the calls are assigned and the stock sold at the options strike price? The if-called return also represents the strategy s best-case scenario, the maximum return that can be realized. In dollar terms, the most that a buy/write can earn is the appreciation of the stock from its purchase price to the options exercise price (assuming that the calls written were out-of-the-money) plus the option premium obtained in initiating the strategy. Continuing with the same example used in calculating the static return, if XYZ is purchased at $57 and the August 60 calls written for $1.70, the stock s potential appreciation is $3 (from a purchase price of $57 to the options exercise price of 60) and the options premium remains $1.70. The if-called return is then: ($3 + $1.70) / ($57 - $1.70) = 8.5% Once again, it is customary to annualize this return, with the same formula used with the static return: (8.5% X 365) / 70 = 44.3% annualized As with the static return any dividends that accrue to the investor during the lifetime of the option should be added to the investor s profit. Roll your mouse over here for clarification. A note of caution: some buy/writes will post eye-popping if-called returns. Investors must remember two facts when looking at these returns: 1) the if-called return will only be earned if the underlying stock rises above the options exercise price by the expiration date. This may represent a substantial rise in a short period of time. And 2) an investor may not be able to realize the annualized returns based on relatively short periods of time (such as 70 days in our scenario above) on a consistent basis. If the buy/write in our example does earn its 44.3% annualized rate of return, there is no guarantee that in 70

7 days another comparable buy/write with a comparable rate of return will be available. Stock Outlook A buy/write is most appropriately defined as a neutral to moderately bullish investment strategy. This means it will perform best using stocks that are expected to remain unchanged ( neutral ) or rise slightly ( moderately bullish ). If a stock is expected to rise substantially a more bullish strategy may be in order, although the buy/write will remain profitable if the underlying stock rallies strongly. Comparing Different Buy/Writes for a Specific Stock An investor has decided to initiate a buy/write on XYZ stock, currently trading at $125. She is considering writing either the March 130 calls at $2, or the March 135 calls at $0.90. March options expire in 60 days. She calculates the following annualized static and if-called returns for these two options: 130 Calls 135 Calls Static Return 9.9% 4.4% If-Called Return 34.6% 53.4% She notes that the 130 calls offer the higher static return and the 135 calls the higher if-called return. Is one buy/write better than the other? No. And herein lies one of the decisions every investor who initiates a buy/write must make: which strike price should be chosen. A few points to keep in mind when deciding between various strike prices: There is a greater probability of earning the static return than of earning the if-called return, since the former only requires the underlying stock to remain unchanged, whereas the latter needs the stock to rise to the options exercise price. When comparing two options, the at-the-money (or the one closest to being at-the-money) will have a higher static return, the out-of-the-money the higher if-called return. The further a call is out-of-the-money, the greater the proportion of the potential return that comes from stock appreciation, and the more the position starts to look like a straight stock position. There is unfortunately no best option that can be written, just choices between higher static and higher if-called returns. Section 3 - The Buy/Write Comparing Buy/Writes on Two Different Stocks An investor is looking to initiate a buy/write and has narrowed her choice to two stocks: XYZ and ZYX. She calculates static and if-called returns with the November options (72 days until expiration) and obtains the following annualized numbers: Static Return If-Called Return XYZ 5.1% 21.2% ZYX 7.4% 29.9% At first glance ZYX would appear to be a better choice: it offers both a higher static and a higher if-called rate of return. But there is a reason that

8 both rates of return are higher for ZYX: the options premiums are higher, indicating that the market is pricing these with a higher volatility estimate. In other words, the options on ZYX are relatively higher because the market views ZYX as a more volatile, and therefore more risky, stock. The covered write on ZYX is not better than the one on XYZ it simply offers a different risk profile: higher potential return for taking on a higher level of risk. As a rule of thumb, abnormally high rates of return generally come with higher degrees of risk. Whenever investors find buy/writes with abnormally high rates of return they must realize that these come at the cost of assuming a higher degree of risk. Buy/Writes: Possible Outcomes at Expiration If an investor has initiated a buy/write and takes no action prior to option expiration, there are only two possible outcomes: the calls will either expire worthless, or the investor will be assigned and the underlying stock sold at the options expiration price. (In the next section we will explore possible actions to be taken prior to expiration). Stock above options exercise price : If on expiration Friday the stock closes above the options exercise price, it is more than likely that the options will be assigned and the investor who initiated the buy/write will be forced to sell the underlying shares at the options strike price. The strategy will then have earned its if-called return, the highest return it can generate. Stock below the options exercise price : If on expiration Friday the stock is below the options exercise price, the options will expire worthless and the writer s obligation will be terminated. On the Monday following expiration the investor will then have the opportunity to write another series of call options. For example if the June options ceased trading on Friday the 18th, on Monday the 21st an investor could write July or August options if she wanted to continue with the buy/write strategy. If the underlying stock is unchanged or close to unchanged, calls with the same strike price as the June options can probably be written. If the stock is down by more than a few dollars, the investor who wants to continue writing covered calls may have to select a lower strike price than that of the June options, a situation that could eventually produce a loss. For example assume the stock was originally purchased at $43, and the June 45 calls sold for $1. If at the June expiration the stock is trading down at $38 the June calls would expire with no value. On Monday after expiration July 40 calls could be sold for $1. Since the investor s initial investment was $42 ($43 initially paid for the stock less the $1 premium received from the sale of the June calls), writing the July 40 calls reduces this by another $1 to $41. If the stock is above $40 at July expiration and the investor is assigned on the short July 40 calls, the net loss on the strategy would be $1 per share since a total of $41 was invested but only $40 generated on the sale of the stock from the assignment. Some investors may not want to write the 40 calls since they are locking in a loss, others may be willing to do so since absorbing losses is part of investing. Section 4 - Managing Buy/Writes If an investor enters into a covered write or a buy/write and does not take any follow up action, either the written calls will expire worthless or they will be assigned or assignment can be expected and the underlying stock sold. In certain circumstances doing nothing may be the preferred outcome; at other times follow-up action may be appropriate given an investor s outlook for the underlying stock. This section looks at the most often used managing strategies: rolling out, and rolling up and out. Rolling Out Assume an investor is long shares of XYZ against which he has sold some February 50 calls. It is now the Monday before expiration, XYZ is trading at $52.60 and our investor knows that if he does nothing over the next 5 trading days and the price of XYZ remains above $50 he will be assigned on his short calls and forced to sell his shares at $50.

9 Looking at the option marketplace he finds the following: February 50 calls: $ $2.90 March 50 calls: $ $3.90 Our investor considers rolling out his call position to March. This consists of buying back the short February 50 calls at $2.90 and simultaneously writing the March 50 calls for $3.70, for a net credit of $0.80. Rolling out accomplishes two things: first it generates a net cash flow of $0.80 per share, and second, it extends the investor s obligation to sell his shares by an additional 28 days (the number of days from the February to the March expiration date). Is it worth the investor s while to roll this position? First, calculate the investor s return for the incremental time period. If nothing is done, the stock will be sold at $50 and the investor will have $50 to re-invest somewhere else. If the position is rolled to March, $0.80 per share is generated. So the return on the roll is This return can be annualized as follows: $0.80 / $50 = 1.6% (1.6% X 365) / 28 = 20.8% annualized In deciding whether or not to roll his position, this investor should consider the following: Is he comfortable holding XYZ an additional 28 days? Is a 20% annualized rate of return sufficient compensation for holding these shares, remembering that they could drop below $50 before the March expiration? What level of return can the investor generate from other investments with comparable risks to rolling out their February options and extending the term of their covered write? Remember that if XYZ is expected to go ex-dividend sometime between the February and the March expiration date, then this dividend should be included in the calculation of the roll s return. Also note that rolls can be done as one order. Roll your mouse over here for information on placing a roll order. Section 4 - Managing Buy/Writes Rolling Up and Out Sometime ago, an investor initiated a covered write on XYZ, writing the January 55 calls. It is now one week before January option expiration and XYZ has risen to $ The investor knows that doing nothing will most probably result in assignment and the sale of her XYZ stock at $55 per share. She has considered rolling her short January 55 calls to the February 55s but her outlook on XYZ is quite bullish over the short term and she is considering rolling her option position up (to a higher strike price) and out (to a further expiration date). Selected option prices on XYZ are given: January 55 calls: $ $2.20 February 60 calls: $ $1.70 March 60 calls: $ $2.80 She considers the following two rolls: first, rolling up and out to the February 60 calls. She likes the fact that this roll only extends the strategy for one month, but she realizes that to do so will require her to put up additional capital as the roll can only be done for a $0.70 debit (buy the January 55s at $2.20 and sell the February 60s at $1.50). The second possibility is to roll up and out to the March 60s instead of the February 60s. This roll can be executed for a $0.40 credit (buy the January 55s at $2.20, sell the March 60s at $2.60), a net advantage, but it also requires her to commit herself to this new position for an additional two months. How to decide?

10 There is obviously no one correct answer. This investor should weight the following: her comfort level in holding XYZ an additional month or two; her willingness (or reluctance) to commit additional funds to this position; her estimated likelihood that XYZ will rally to $60 or above over the next month or two (remembering that if she does roll her position up and out, the strategy will then reach its highest profitability if XYZ rallies above $60). When to Roll Positions The question arises as to how early, or how close to expiration investors should wait until they roll covered calls (either out, or up and out). Two factors must be balanced: first, the longer an investor waits, the more the time premium on the existing short option position decays and the cheaper it becomes to cover those written calls; second, there is always the possibility of early assignment. If the calls are assigned before they have been rolled, the whole discussion becomes moot, as the investor no longer holds the stock and no longer has a short position in the expiring options. Other Possible Rolls The two rolling strategies described above, rolling out, and rolling up and out, are by far the most often used managing strategies for covered writes. In specific instances investors may also want to investigate the feasibility of the following strategies: Rolling down : Moving from a higher to a lower strike price, keeping the same expiration date. For example, rolling from the July 45 calls to the July 40 calls. Usually done when the underlying stock has declined in price and a more defensive position is desired. Rolling down and out : Moving from a higher to a lower strike price while pushing out the expiration date. For example, rolling from the October 35 calls down to the December 30 calls. Once again, usually done when the underlying has declined in price and a more defensive position is desired. Rolling up : Increasing the strike price while maintaining the same expiration date. For example rolling from the June 60 calls to the June 65 calls. This roll can only be done for a debit and is used when investors have become more bullish about the underlying stock and are trying to capture more of its upside. See below to review the risks of early assignment. If no dividends come into play, the risk of early assignment can be assumed to be relatively low and it is not uncommon for investors to wait until just a few days prior to expiration before rolling their positions. But also remember that the risk of early assignment increases the further in-the-money the calls move. Early Assignment All equity options are American-style options, which means that their holders (buyers) have the right to exercise them on any business day, up to and including expiration Friday. The flip side of this, is that the writer of an equity option is at risk of being assigned early. Two questions need to be answered: can the risks of early assignment be quantified, and is early assignment a negative or a positive? To quantify the risk of being assigned early on written calls, it is best to view this question from the perspective of the option holder, the investor who purchased call options. Assume an investor purchased some September 50 call options. The underlying stock is now trading in the $54-$55 range. Should this investor exercise his options early? The 50 calls give this investor the right to purchase shares at $50. He could do so today, but he could also do so tomorrow. Is there any advantage in exercising this right today? Not really. Is there any point in waiting until tomorrow? Yes. Assuming that this investor has the cash necessary to purchase the underlying shares, waiting until tomorrow to exercise means postponing the purchase by one day. This means that the cash can be retained and earn interest for an additional day. Of course, tomorrow the same analysis can be made again and the purchase deferred another day to earn another

11 day s worth of interest. The option holder has one very good reason to postpone exercising his calls: the longer he waits, the longer his cash earns interest. Therefore, early exercise/assignment of calls is relatively rare as there is no economic justification in spending money today when it can be spent later. There is, however, one exception to this, and that is when the underlying stock is about to go ex-dividend. The question facing the call holder is: do I wait until immediately prior to expiration and keep earning interest on my cash, or do I exercise on the day before the stock goes ex-dividend, spend the cash early but collect the dividend? When equity calls are exercised early it is in most instances for a dividend. Call writers should therefore be aware that the risk of early assignment is at its highest immediately prior to the underlying stocks s ex-dividend date. But is being assigned early a negative event? The writer of a covered call knows that at best she will sell her stock for the options exercise price. Being assigned early simply means selling the underlying stock earlier rather than later, and at the same price. Most investors would prefer to get paid today rather than tomorrow, and early assignment may be viewed as a positive. Rolling